The period following the financial crisis is most notably associated with monetary policy tools such as quantitative easing (QE) and negative, or zero, interest rates. It is understandable why these have taken the spotlight given the debates they caused around their legality and their unintended consequences.
In an effort to go back to basics, central banks these days affirm that their primary tool is setting interest rates. The expectation is that, by raising interest rates, consumers will be more inclined to save money as borrowing to consume (for example car loans) has become more expensive. For companies, the rising cost of borrowing makes them more selective about putting capital to work in new projects. The expected culmination of these effects is to cool the economy with the reverse expectation when interest rates are lowered.
Going back to QE, the expectation was that by improving the flow of money, demand would pick up and they could resort to more normalised policies. However, given the world was very interconnected with few impediments to trade, the supply side of the economy proved very responsive to demand. This meant that price pressures were incredibly muted in that period. Hence, when central banks saw any large signs of weakness, they opted for increased QE or moved rates further into negative territory as demand was seen as the issue.
The policy framework that does not get as much focus is forward guidance. In periods where you see little change in policy, communication becomes the main tool policymakers used to steer markets. That made a lot of sense after the financial crisis, given the balance between supply and demand.
So forward guidance became seen as a vital part of the central banker’s arsenal.
Looking back at the events of recent years, it is the confidence that this tool represented that got policymakers into hot water. With hindsight, the combination of both fiscal and monetary policy loosening in the face of a less responsive supply side is a recipe for inflation. However, central bankers found it harder to adjust policy given the forward guidance they provided.
This meant the period to recalibrate expectations from loose policy stance to tight took longer and resulted in a more aggressive hiking cycle. Investors and the press had become accustomed to this more explicit communication style and continue to press central bankers for this.
With the rate hiking cycle seemingly in the last innings, clarification around the so-called “pause” in interest rate rising continues to be of much debate.
This week, we had policy announcements from the Federal Reserve (Fed), European Central Bank (ECB) and the Bank of Japan (BoJ). As was widely expected, both the Fed and the ECB raised interest rates by 0.25%, to 5.25-5.5% and 3.75% respectively.
In their June meeting, the ECB provided a strong indication that they would hike in July. This time around, the risk of inflation was highlighted but there was also an acknowledgement that surveys are showing weaker economic momentum. When pressed about that path of rates going forward, President Lagarde tried to find many ways of communicating a total dependency on incoming economic data.
The picture was similar for Fed Chair Powell who said that rates are now in restrictive territory, the current level being the highest in 22 years, but offered little clues to future action. While highlighting data dependency and a level of uncertainty surrounding the lagged effects of prior rate hikes, the Fed is taking no chances and not tying itself to a policy stance.
While many expect these hikes to be the last of the cycle, by not communicating this, we can see that forward guidance is now destined to be retired towards economic textbooks.
The communication stance has shifted to favour flexibility over dampening market volatility.
While those actions proved no real surprise, the BoJ decided it was up to them to deliver that surprise. Towards the end of last year, the Japanese central bank surprised investors by widening the band around the Yield Curve Control (YCC) policies. This increased speculation of larger adjustments to policy down the road. Expectations were building that, when Governor Ueda took the helm, he would start the process of more meaningful policy shifts. However, those expectations proved early as the BoJ instead announced a review that would take between 12-18 months to complete. This saw the Yen weaken around 8% versus the dollar over the second quarter. Furthermore, following the re-opening at the end of last year, economic growth has been solid, thus putting upward pressure to domestic drivers of inflation. This prompted a less firm commitment this morning to stick to the bands around the YCC policies. Governor Ueda was quick to push back on those speculating that this is another step towards normalisation with more tweaks to come, but this has fallen on deaf ears. Communication will be challenging as Japan faces an enormous debt pile, with even a small increase putting an enormous strain on government budgets.
Going forward, every meeting is likely to be a “live” one, thus adding to market volatility. As such, it has become increasingly clear that in era where the predictability of economic models has faded, forward guidance is no longer a desirable tool.
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